Writing about random topics

The bailout and how we got into this mess – part 3

Continuing on in my series about banks and bailouts, we saw last time that banks used to loan out money based upon actual assets in their deposits. So long as there wasn’t a bank run, they’d be alright. However, with the rise of central banking in the nineteenth century, everything changed. In the United States, this is the Federal Reserve, and it has the power to create money. It is the power of central banking that allows for the implementation of credit expansion.

Central Banking

In 1971, President Nixon took the United States off of the gold standard. What that means is that no longer is the currency in circulation backed by any physical asset. Whereas prior to that, $1 dollar theoretically meant that $1 in gold existed in a bank reserve (actually, maybe 1/10 of that amount due to banks being able to loan out that amount), now, $1 is backed upon nothing but a good faith assertion that the note is legal tender, as issued and guaranteed by the government. In the United States, the government does not issue the money. Surprised? Well, it’s true. Get out a note of currency and read it for yourself, at the top of the bill it says "Federal Reserve Note." If you live in Canada or England or wherever, it’ll say something similar for the country you live in.

The Federal Reserve in the United States is a group of 12 private banks. It is not a public institution (in theory). This means that a private institution is in charge of regulating and monitoring the value of money (and the way I read Article I, Section X of the Constitution suggests that this is illegal). So what is the problem with central banking?

To put it simply, a central bank has the power to inject or remove money from circulation. When based on the gold standard, a central bank can say to other banks — that do loan out money, as the Fed itself does not loan money out — what the reserve requirements are. For example, the Fed can say that banks must have a minimum expense deposit ratio of 10:1. To put it in plain English, a bank can only loan out a maximum of $10 for every $1 it has in its deposits. The Fed can later on say that the deposit ratio is 15:1, and then shrink that down to 8:1. So, if the ratio is 10:1 one day and all the banks in the United States have $100 million in deposits, then they can loan out $1 billion (100 million x 10) into the general population. Banks have an interest in loaning out as much money as possible because they can charge the borrow a certain rate of interest. Just consider it: if you pay 2% interest on $100 million, it will cost you $2 million per year. But if you charge 6% interest on $1 billion, you make $60 million per year. Not a bad way to make a living, I’d say.

If the Fed then says that reserve requirements are now 8:1, and banks only have $100 million in deposits, then they can only loan out $800 million. But if previously they had loaned out $1 billion, then they now have to reel in $200 million. This can occur by calling in bad loans; it is also known as shrinking the money supply.

Money and Inflation

I need to take a jump from talking about banking to talking about inflation. When we use the term inflation, most people generally think that it is a gradual increase in prices over time. That’s not technically correct; rising prices is caused by inflation, but it is not the definition of inflation.

Money is a commodity like anything else. Like any commodity, it is driven principally by two factors: supply and demand. Consider a Tickle Me Elmo doll. Back in the 1990’s, there were not a lot of these things kicking around and the price of them skyrocketed. High demand + low supply = high prices. Oil is (or rather, it was) in demand and the supply was not increasing. Therefore, it’s price increased. Conversely, the real estate market now has a ton of supply and low demand, therefore, prices are crashing.

Just like oil, real estate, and Tickle Me Elmo, money’s value is also affected by supply and demand. If there is $1 million worth of gold in circulation, then market force (which constantly adjust) set the value of goods. There are a certain amount of actual, tangible goods and services out there in the market. The Invisible Hand looks at everything and calculates that x amount of dollars by y amount of goods. This value is constantly in flux. If only $1 million worth of gold stays in circulation, and more and more goods come into production, then money is becoming more rare relative to other goods. In other words, demand for money (to buy more stuff) increases while supply stays the same. Increased demand for money increases its buying power. To put that another way, if that actually happened, your money would actually buy more stuff tomorrow than it does today.

On the other hand, let’s say that Terry’s Great Gold Company all of a sudden discovered a gold mine in his backyard. There was so much gold that the amount of gold in circulation could be doubled within two years. What would happen? Well, because there would now be more gold, and dollars were backed by gold, then the amount of money in circulation would increase. There would now be more dollars chasing the same amount of actual, physical goods in production. The value of money would decrease since there is now more supply (money) demanding the same amount of goods (stuff). Of course, the goods would gradually increase over time, and the market would adjust itself as if by magic (but in reality by The Invisible Hand).

The point is that when more money is injected into the money supply, you have increased supply of dollars. Increased supply means that the market will eventually adjust and it will take more dollars to buy the same amount of goods, assuming that the market doesn’t react by expanding to offset amount of dollars increased in the market. If it doesn’t, then it means that prices of goods will increase. Rising prices is the result of inflation of the money supply.

History shows that the market has not adjusted to an increase in the money supply. The proof is that $1 today buys far, far less than it did 30 years ago. Or even 20 years ago… even 10 years ago. As central banks have increased the supply of money, it’s value has decreased.